Thursday, February 16, 2017

Unit Economics: Cost Types and the Stages of Business Growth

As I've written before, start-ups should use variable costs whenever possible, growth stage companies should shift to using fixed period costs as revenues stabilize, and mature companies with lots of cash on the balance sheet should invest in primary sunk investments. But why is this true?

Start-ups typically have minimal cash to invest, need to prove the business model and market demand, and are more susceptible to risk. As a result, it's better to use variable costs whenever possible because variable costs don't require large cash investments, allow you to run fast and inexpensive tests to prove whether your current approach is viable, and allow you to more easily pivot and adjust to changes in your market. In this phase, maximizing contribution margin or gross margin is less important than simply surviving, which variable costs can help you do. In contrast, Fixed Period Costs, by definition, need to be paid every month, meaning that if you have a slow month of sales, you'll go bankrupt. Similarly, Primary Sunk Investments, say, in vehicles, land, or equipment, can easily become prohibitively expensive. It's better to simply pay for services only when you need them, at least until you need them a lot.

Then, as you grow, your revenues become stable. You know your customers and market well. You can reasonably predict steady or growing cash flows for the coming months or years. At this point, you can begin to invest in longer commitments such as equipment leases or long-term contracts and subscriptions. By doing so, you can decrease your variable costs and increase your contribution margin. You have a lot more customers to pay for those overhead costs, making them relatively affordable now. Your pre-tax cash flow (aka EBITDA) will increase and your Break Even unit sales per month will decrease.

However, you're still growing, still reinvesting every last dollar back into the business that you can. You're still susceptible to big shifts in the market or retaliations by large competitors. You also need to keep some cash on hand for a rainy day. You're probably not even paying yourself, as the owner, much in salary or distributions yet. And you may not have hit payout and earned back the original investment yet. Therefore, it doesn't yet make sense to spend large amounts of capital on Primary Sunk Investments just yet.

Fast forward a few years, and now you've grown substantially. You've attained respectable market share. Even though the potential for double and triple digit growth may be forever behind you, your revenues and profits are higher than you ever dreamed possible. More importantly, your retained earnings are large, meaning both you and your company have lots of cash just sitting in the bank. Hundreds of thousands of dollars, millions of dollars, or more are burning a hole in your pocket, but you don't want to be stupid and waste it, and meanwhile upstart competitors are nipping at your heels.

What should you do with all that cash? You could invest it in the risky stock market and get an 8% return, if you're lucky, but that doesn't help the company at all. Instead, you decide to put it back to work directly into the company on projects you know you could get a 20% or even a 200% return. Perhaps this investment will increase your capacity, help you become more efficient, or help you grab still more market share. For example, by buying expensive equipment and buildings, you could dramatically decrease both Variable and Fixed Costs forever. As a result, you could enjoy higher contribution margins, or you could lower your prices to out-compete the market and earn more customers, or perhaps you could even do both at the same time. It's a big win either way. The only question is what you'll do when that investment pays off and you have even more cash to invest in a year or two, but that's a good problem to have.